Best Thing when Considering Raising Money

How to Understand & Predict New Markets

“[VCs] are obsessed with market size [seeking a billion dollar + market]. [] (Smaller, venture-style investors like angels and seed funds also prioritize market size but are usually more flexible – they’ll often invest when the market is “only” ~$100M). [] VC returns tend to be driven by a few big hits in big markets.

For early-stage companies, you should never rely on quantitative analysis to estimate market size. Venture-style startups are bets on broad, secular trends. Good VCs understand this. []

The only way to understand and predict large new markets is through narratives. Some popular current narratives include: [] social link sharing is becoming an increasingly significant source of website traffic and somehow will be monetized; mobile devices are becoming powerful enough to replace laptops for most tasks and will unleash a flood of new applications and business models.

“An extremely useful concept [] popular among startup founders is what [] entrepreneur and investor Marc Andreessen calls “product/market fit”, which he defines as “being in a good market with a product that can satisfy that market”. Andreessen argues persuasively that product/market fit is “the only thing that matters for a new startup” and that “the life of any startup can be divided into two parts: before product/market fit and after product/market fit.”

But it takes time to reach product/market fit. [] [Dixon believes that] the best predictor of whether a startup will achieve product/market fit is whether there is [] “founder/market fit” [meaning] founders have a deep understanding of [their market], and are people who “personify their product, business and ultimately their company.”” Chris Dixon, Founder/market fit, June 19, 2011; http://cdixon.org/2011/06/19/foundermarket-fit/

“Come up with what minimum valuation you’d be happy with but never share that number with any investor. If the number is too low, you’ve set a low ceiling. If your number is too high, you scare people off. [You] only get to your desired price by starting lower and getting a competitive process going. When people ask about price, simply tell them your last round post-money valuation and talk about the progress you’ve made since then.” Chris Dixon, Best practices for raising a VC round, May 4, 2011; http://cdixon.org/2011/05/04/best-practices-for-raising-a-vc-round/

“[] if [an entrepreneur] expect[s] to raise more money (and [he] should expect to), make sure [the] post-money valuation is one that [he’ll] be able to “beat” [exceed] in [the] next round. There is nothing more dilutive and morale crushing than a down round.” Chris Dixon, Ideal first round funding terms August 16, 2009; http://cdixon.org/2009/08/16/ideal-first-round-funding-terms/

“The earlier stage your company is the more you should weight quality of investors vs valuation. For a Series A, you are truly partnering with the VCs. You should consider taking a lower valuation from a top tier firm over a non top tier firm (but probably any discount over 20% is too much). If you are doing a post-profitable “momentum round” I’d just optimize for valuation and deal terms.” Chris Dixon, Best practices for raising a VC round, May 4, 2011; http://cdixon.org/2011/05/04/best-practices-for-raising-a-vc-round/

Dixon says that tranching can create a misalignment of investors’ and entrepreneurs’ interests. “[] tranching refers to investments where portions of the money are released over time when certain pre-negotiated milestones are hit. [] In theory, tranching gives the VCs a way to mitigate risk and the entrepreneur the comfort of not having to do a roadshow for the next round of financing. In practice, [Dixon has] found tranching to be a really bad idea.

[][Tranching] encourages the entrepreneur to “manage” the investors [hurting VC-entrepreneur relations, among other things]. One of the great things about properly financed early stage startups is that everyone involved has the same incentives – to help the company succeed. [] When the deal is tranched, the entrepreneurs ha[ve] a strong incentive to control the information that goes to the investors and make things appear rosy. The VC in turn usually recognizes this and feels manipulated. [] There are better ways for investors to mitigate risk – e.g. lower the valuation, smaller round size. But don’t tranche.” Chris Dixon, The problem with tranched VC investments, August 15, 2009; http://cdixon.org/2009/08/15/the-problem-with-tranched-vc-investments

“I prefer to think of dilution over the life of the company. Sometimes you give up more now to give up less later. [] I gave up 50%+ of SiteAdvisor to investors in the first round but in the long run was happy for it.” That said, Dixon recommends raising “as much as possible while keeping [] dilution under 20%, preferably under 15%, and even better, under 10% [especially] for founders who aren’t experienced “developing and executing operating plans”.”

“[] I know it sounds self serving as a seed investor but the path to least dilution is investors aligned with you on seed round where you don't raise too much money, and then raise the bulk of your money later.” Chris Dixon, What’s the right amount of seed money to raise? Comments, December 28, 2009; http://cdixon.org/2009/12/28/whats-the-right-amount-of-seed-money-to-raise/

The short answer for how much seed money to raise is “[] enough to get [a] startup to an accretive milestone plus some fudge factor” of say, a 50% round size increase.

““Accretive milestone” [means] getting [a] company [where it] can raise money at a higher valuation” and is a function of market conditions and the startup’s nature. “As a rule of thumb, [] a successful Series A is one where good VCs invest at a pre-money [valuation] that is at least twice the post-money of the seed round. So if [a] seed round [] raised $1M at $2M pre ($3M post-money valuation), [] the Series A [] should be [] a minimum of $6M pre (but hopefully [] significantly higher).

The worst thing a seed-stage company can do is raise too little money and only reach part way to a milestone. Pitching new investors in that case is very hard; often the only way to keep the company alive is to get the existing investors to reinvest at the last round valuation (“reopen the last round”). The second worst thing [] is rais[ing] too much money in the seed round [], hence taking too much dilution too soon.”

When entrepreneurs raise seed money (under $1 million) from big VC firms’ seed programs, potential investors typically ask ““is the big venture firm following on [with financing]?”” If not, entrepreneurs will likely have difficulty raising more money because potential investors will question why they should invest if the big VC firm doesn’t. “[When entrepreneurs take big VC’s seed money], [] effectively [they’re] giving [the VC a non-contractual] option on the next round, [acting as a VC lead generator.] And, somewhat counterintuitively, the more well respected the VC is, the stronger the negative signal will be when they don’t follow on.

[When] the VC does [] follow on, [the company will likely] get a lower valuation than [had it] taken money from other sources” because new investors often offer to co-invest at a lower valuation, keeping an artificially low valuation or “hesitate to [bid] for fear of being used as [leverage to get a higher priced deal]. [] [Having] a big VC [] as a seed investor [] prevent[s] [the entrepreneur] from getting a competitive dynamic going that [generates] a true market valuation.